Dr Gerard Lyons is a senior fellow at Policy Exchange. He was Chief Economic Adviser to Boris Johnson during his second term as Mayor of London.
Higher inflation, a prolonged recession and rising unemployment. That was the bleak forecast from the Bank of England last week when it released its quarterly Monetary Policy Report.
Alongside it, the Bank hiked policy rates by 0.5 per cent from 1.25 per cent to 1.75 per cent. The rate hike pleased few. With inflation at 9.4 per cent and forecast to exceed 13 per cent, monetary policy appears too loose.
But, if the economy faces recession and with external influences driving inflation, it can be asked: why is the Bank hiking aggressively?
Importantly, the Bank’s forecast is based on the assumption of no further fiscal action. But it is likely there will be further fiscal stimulus from the next prime minister to alleviate downside economic risks.
Monetary policy leaves much to be desired. It is not a new problem, but because the Bank is independent it has tended to avoid the rigorous scrutiny it should receive.
Sometimes it seems as if the Bank has become effectively an offshoot of the Treasury. It oversees and chairs every selection committee to choose the Court of the Bank, governor, deputy governors and members of every policy committee. The mandarins recommend to the chancellor who should be governor or deputy governors.
There is effectively a revolving door from the Treasury to Threadneedle Street. Three of the Bank’s five deputies used to be at the Treasury.
This is hardly a recipe for tackling groupthink. External members hardly seem to be chosen for their diversity of thought.
Some commentators are up in arms that Liz Truss wants to hold the Bank to greater scrutiny. Apparently this is seen as a threat to its independence. What rubbish. Politicians are not going to set interest rates. The Bank will thus remain independent.
Increased accountability should be welcomed and its mandate should be reviewed to see if it’s best suited to the economy’s changing needs.
Ironically, the Bank’s actions last year hardly displayed independence when it engaged in £450 billion of Quantitative Easing (QE), matching increased government spending and the wishes of the Treasury.
Crucially, the Government could have funded itself through the markets, where borrowing rates were very low. What commentators often miss is that the Bank didn’t need to print £450 billion and should have said no.
Instead, if it was doing its job, the Bank should have embarked upon a tightening phase. With inflation hitting 0.7 per cent last February it was clear it would rise, monetary growth was rapid and the economy looked set to rebound solidly. The economy would have coped with monetary tightening. Instead the Bank did the opposite and eased through QE.
This isn’t being critical with the benefit of hindsight, these points were made at the time.
Sadly, the rot set in some time ago. We effectively moved to an era of cheap money in the wake of the 2008 global financial crisis. Rates justifiably fell towards zero as a result of that crisis, but the problem was that they should have been returned to normal. They weren’t.
This led financial markets to not price properly for risk. A mis-allocation of capital followed. Zombie firms stayed afloat. Cheap money fed asset price inflation, including rampant property prices.
It was not just policy rates, though. The Bank’s balance sheet exploded because of its asset purchases, with QE distorting gilt yields and the Bank even strayed into buying corporate bonds.
Its actions, through low policy rates and a bloated balance sheet, have not helped in the present inflation shock.
To be clear, this is largely an external inflation shock driven by supply chain problems and higher fuel prices. There is not much the Bank could do about this.
But its actions last year exacerbated the inflation shock and also left the economy in a difficult situation. This is not fully appreciated. Because it eased last year as opposed to tightening, policy is far from where it should be. But if the Bank tries to overcorrect now, the economy will suffer.
Two wrongs do not make a right. The first wrong was the inappropriate monetary policy last year. The second would be to try and make up for that now.
It is commonplace to hear that even if policy had been tighter last year inflation now would not be much lower. What this fails to appreciate is that if last year’s QE had not occurred, and if policy rates had risen, then not only would the economy have coped, but also policy would be closer to where it should be. As a result there would likely be fewer economic casualties, in terms of lost output and job losses, to rates having to tighten now.
Also, at the press conference, one deputy governor stressed that inflation had averaged two per cent over the last twenty-five years, as if this offered protection to being held to account now.
It’s ironic (and telling) that the Bank is keen to stress the external influences pushing inflation higher now, while overlooking the global influences that previously kept inflation low.
China’s entry into the World Trade Organisation in 2001 was perhaps the single most important factor keeping global and British inflation low. In the City, the CPI was nicknamed the ‘China Price Index’.
A year ago, I asked which ‘p’ would the rise in inflation be: pass-through, persist, or permanent? I thought the Bank was wrong to believe it would pass-through quickly. I felt it would persist. It doesn’t look like it will be permanent, with financial markets recently expecting global inflation to ease next year.
But for an institution with one job to do – keep inflation low – the risks were clear then.
The global nature of the current inflation shock naturally should make the Bank move carefully. The speed, scale and sequencing of rate hikes and reversal of QE via Quantitative Tightening needs to be sensitive to how the economy performs and responds.
As with other European countries we face not only the energy price hike but also, as with the US, a tight labour market too. Thus the Bank needs to be mindful of second-round inflation effects, where firms are able to pass on higher costs to maintain margins and higher wages trigger a wage-price spiral.
Interestingly though, the nature of our inflation shock is not that of an overheating economy; this not only vindicates the case for a more proactive fiscal stance, but also suggests the Bank move gradually.
In the financial markets the Bank is suffering from a credibility gap. Despite the fact it hiked rates this winter, before the US, its poor communication has not helped – and whereas the Federal Reserve is now seen as ahead of events, the Bank is viewed as playing catch-up. The strength of the dollar too has led to sterling, like the euro, appearing vulnerable.
The dismal nature of the press conference stood in sharp contrast to the Fed, who while also facing a tough time are both realistic and reassuring.
In a recent speech the governor talked of how, “the long-run anchor for UK equilibrium interest rates, will remain low.” He was referring to r-star, the neutral rate of interest after allowing for inflation. This should concern us, given the distortions caused by low policy rates since 2008.
It should raise questions as to whether we will learn anything from the prolonged period of cheap money? Learning from policy mistakes suggests that whenever the economy stabilises, rates should then settle even higher for future monetary stability.